Deep Hedging Bermudan Swaptions

TL;DR

This paper introduces a deep hedging framework for Bermudan swaptions that overcomes traditional model limitations, improves residual P&L control, and incorporates a novel Option Spread Hedge strategy, with promising numerical results.

Contribution

It applies deep hedging to Bermudan swaptions, addressing practical market issues and introducing an innovative Option Spread Hedge for better robustness and interpretability.

Findings

Deep hedging improves residual P&L management.

The approach effectively handles early exercise features.

Numerical results validate the method's robustness.

Abstract

Abstract This paper proposes a novel approach to Bermudan swaption hedging by applying the deep hedging framework to address limitations of traditional arbitrage-free methods. Conventional methods assume ideal conditions, such as zero transaction costs, perfect liquidity, and continuous-time hedging, which often differ from real market environments. This discrepancy can lead to residual profit and loss (P&L), resulting in two primary issues. First, residual P&L may prevent achieving the initial model price, especially with improper parameter settings, potentially causing a negative P&L trend and significant financial impacts. Second, controlling the distribution of residual P&L to mitigate downside risk is challenging, as hedged positions may become curve gamma-short, making them vulnerable to large interest rate movements. The deep hedging approach enables flexible selection of convex risk measures and hedge strategies, allowing for improved residual P&L management. This study also addresses challenges in applying the deep hedging approach to Bermudan swaptions, such as efficient arbitrage-free market scenario generation and managing early exercise conditions. Additionally, we introduce a unique "Option Spread Hedge" strategy, which allows for robust hedging and provides intuitive interpretability. Numerical analysis results demonstrate the effectiveness of our approach.